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Bear markets without recession tend to be brief

15 January 2016

The somewhat expected recovery rally early in the week wasn’t sustained, and towards the end of the week, markets were back to where they had fallen to the previous week. Since the year began only a fortnight ago, this amounts to 7-10% depending on which stock market one looks at - and even more when looking at emerging markets. Whenever these sort of corrections occur and clients grow concerned about their own investments, it is worth having a look at the impact on actual investment portfolio returns.

This is why I started this edition with a chart of portfolio returns. These are not the returns of our managed portfolios (which we are not permitted to show here for compliance reasons) but those of our benchmarks at their various risk levels. Our managed portfolios look a bit better than the benchmark, because of the more defensive stance we adopted back in September. Compared to the market falls, actual investment portfolios will have suffered declines between 0.05% and 5% (appr.). While it is hopefully reassuring to investors that the risk mitigation measures in their chosen risk profile are doing their job, negative returns is nevertheless not what we want to see.

So, what is happening and will this end at some point? What started as a sell-off, triggered by clumsy market interventions by China, has morphed into a full blown market correction of the same proportions that we had last year in September. Both times, the main driver after the initial trigger were concerns over future global economic growth and the impact this may have on corporate profits and thereby the longer term value of company shares. Last year, the slump very quickly turned into a recovery rally when the quarterly earnings announcements proved that, except for the oil and commodities sectors, the economy remained on a sustained path of improvement and expansion. I strongly believe that it will be the same way around this time and the earnings announcements over the next weeks should calm fears that the economic outlook has suddenly gone into reverse.

However, one element will have worsened. This is once again the energy, oil and commodities sector, where the rapid deflation of the previous price and production bubble is likely to cause a few companies in these sectors to not just underperform, but fail. Therefore, whether markets will quite as quickly turn around into a sustained recovery rally waits to be seen. The potential should be there in terms of corporate earnings progress and general economic data flow.

Watching the markets over the past week, one would be forgiven for thinking that Chinese export and import numbers must have disappointed, when instead they surprised on the upside. The reason is that once downward momentum has built up, stock markets develop a dynamic which is not driven by rationale forward looking assessments but a general lack of liquidity. This happens when leveraged speculators have been caught out wrong footed and have to liquidate across all their holdings in order to cover their losses. On the side of those who are usually buyers, they have either become too fearful or expect to be able to buy even lower a few days later. This only stops when we reach what the market calls capitulation levels.

Characteristics of these levels are accelerating falls to new lows, previously not believed possible against the general economic backdrop. This tends to be the turning point and the ‘bottom-fishers’ come to the conclusion that if they wait any longer before buying, they may miss a very good bargain. On Friday afternoon, while writing these lines it began to feel a bit like we may have reached the point of capitulation. Unfortunately we will only know with hindsight and at least some technical indicators suggested that there may be more pain to come before markets return to gain.

I have been asked all week by advisers and their clients whether they should be alarmed, particularly after some RBS credit analysts managed to release a very alarming outlook in The Telegraph which suggested a cataclysmic crisis. My repeated response has been that, at the moment, the markets are still within what we had anticipated as a possible scenario triggered by the first US rate rise in nearly a decade, which finally occurred in December. We had therefore reduced risk exposures across portfolios and maintained a neutral asset allocation, because the general macro-economic environment and direction does not suggest an imminent economic slowdown or recession. Sustained economic contraction would be the only reason for markets to fall not just in the short term, but stay at lower levels over the medium term. Compared to our peers and the reference benchmarks, this has been value adding for Tatton portfolios, even if returns overall have still disappointed.

It had been our expectation that most of the inevitable pre-first-rate-rise volatility would occur before, not after the rate rise. This had indeed been the experience of 2 years ago, when the first reduction in further quantitative easing was introduced at the same time. There are a number of explanations why this time history didn’t repeat itself exactly and I believe it is the final stage of the unravelling of the commodity bubble which has the most to do with it. As we have repeatedly written on these pages, commodity prices have fallen so much because artificially high prices previously had incentivised the creation of much larger supply capacities than there was actual demand. The deflation of the commodity bubble is therefore not a bad thing, because lower energy and commodity prices will act as a significant demand stimulus for consumers and industry in the foreseeable future.

However, any bubble deflation always brings with it collateral damage. This already happened last year in the form of a drop in industrial demand and, with this latest round of lower commodity prices, it is quite likely that a few commodity related companies will fail and default on their debt. While there is much scare mongering by those who still live under the spell of the Financial Crisis, this type of sectorial catharsis is something that has always happened and there are enough reserves around to digest such ruptures.

Unfortunately there are another two recalibrations of similar size going on at the same time. A slowdown in growth in China and a slowdown in debt financing dependent emerging market countries. The Chinese slowdown also happened mostly last year and was a consequence of harsh but necessary reforms which undermined the confidence of the current industrial elite. The expected emerging market slowdown and subsequent increased levels of debt defaults are a consequence of the US rate rise, as capital from the developed world starts to return to home shores after being deployed offshore over the past decade in search for better yields than those available at home.

Where one of these shifts would have the potential to cause a short market upset, all three together have the ability to confuse the non-economically trained punter community and cause sporadic outright panic. This would apply particularly for those who, in recent years, have made vast profits in all three of the above areas.

In the bigger picture however, capital streams are merely shifting around and growth leadership is (temporarily) shifting from the developing world back to the developed world after the latter is finally overcoming the aftermath effects of the Financial Crisis of 2008/2009. This is why the overall positive economic outlook has not changed and remains positive for 2016. This should, over the course of the year, find reflection in company results and ultimately higher stock markets.

In the shorter term however, the confusion and side-effects of the 3 ongoing re-calibrations are causing capital market gyrations which are unnerving for investors. The worst course of action for investors in such situations is always to crystalize the new status quo and then miss the recovery, which tends to be swift and while concerns are still very live. Sticking to the measured and well diversified investment approach which broad investment portfolios offer, on the other hand, have historically always allowed the level-headed investor to participate in and reap what is available in capital market returns over the longer term.

On this note, I commend a look at the asset class returns table for last year below, which shows what the also very unnerving 2015 brought investors – not a vintage year, but certainly better than cash deposit return:

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